Why Bubble Phobia Is Bad For Your Investing Health

Investment bubbles are relatively rare, despite the proximity of the housing and dotcom collapses. Worrying too much about them could ruin your returns, according to a new report.
By Simon Constable ,

NEW YORK -- Has the investing world completely succumbed to bubble phobia?

Maybe the housing crash and the dotcom bust have addled our brains, but hardly a month goes by without someone warning of a bubble. Is the market for Treasuries in a bubble? What about Silicon Valley startups and junk debt? Is there, perhaps, a bubble in everything?

The problem with that perspective (or rather, the good news) is that financial bubbles just aren't that common, and if you see them everywhere you may be hallucinating.

"Bubbles are booms that went bad, but not all booms go bad," according to a new working paper from the National Bureau of Economic Research titled "Bubble Investing: Learning From History" by William N. Goetzmann, a professor of finance and management at the Yale School of Management.

In fact, only about one in 10 booms go bad, according to the research. So if you are seeing lurking bubbles everywhere you could be missing out on potential gains.

"Placing a large weight on avoiding a bubble, or misunderstanding the frequency of a crash following a boom, is dangerous for the long-term investor," the paper asserts. Why? Because if you scramble for the exit after a rally you'll probably miss loads more gains.

It's a conclusion reminiscent of Warren Buffett's philosophy of investing for the long term.

Goetzmann defines a boom in two ways: "a single year in which a market value (or cumulative return) increased by at least 100% [... or] a period of three years over which the market increased by 100%." Crashes are a 50% pullback over either one or five years, he says.

Not only were busts (i.e., booms gone bad) unlikely, history shows that market prices were more likely to see another doubling after a 100% price gain than to experience a crash.

To draw those conclusions, he analyzed data on stock returns for 21 markets from 1900 through 2014 as well as capital appreciation data from an additional 18 countries starting in 1919.

Although the data was largely from the last century, some earlier examples are cited as well, like that of Genoa-based financial institution Casa di San Giorgio (think of it like an old version of Citigroup.)

"The dramatic doubling of [share] prices in 1602 looks to the modern eye like a bubble," the report states. But "if investors in the shares of the Casa di San Giorgio had sold out in 1603, they would have missed a 20-year boom in prices and would have had to wait 80 years to be proven right."

Truthfully, many may not have lived long enough to get the satisfaction.

Spending time trying to avoid bubbles is also an unnecessary waste of psychic energy. "Worrying about booms is the same thing as worrying about an earthquake tomorrow; people in California know this," says Elena Loutskina, a professor of finance at the Darden Graduate School of Management.

"Bubbles aren't always a bad thing, because when people think there is a brighter future, they tend to spend more," she said. That, of course, boosts the economy, at least for a while.

Bubbles, when they do occur, sometimes give rise to financial innovation. Take for instance the tulip mania of the 17th century in Holland. In addition to causing a lot of people to lose a lot of money, it also saw the rise of the futures contract. People would bid on contracts for the delivery of tulip bulbs at a future date. Ultimately, such contracts gave rise to exchanges such as the CME (CME) - Get Report  and the London Metal Exchange.

Likewise, preventing bubbles can also slow down financial innovation. "In the United Kingdom, the Bubble Act [of 1720 ...] set back the development of an equity market as a vehicle for financing enterprise," the economic research bureau report says. 

But, as the existence of Wall Street shows, it didn't prevent the arrival of the equity markets as we know them -- it just slowed them down.  

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

Loading ...